January 2018 - Reverse-Merger.com

SEC Issues C&DI On Use Of Non-GAAP Measures

Posted by Securities Attorney Laura Anthony | January 30, 2018 Tags: Definition of non-GAAP financial measure and exclusions, New C&DI, Refresher on Regulation G and Item 10(e) of Regulation S-K, Regulation G and Item 10(e) requirements

On October 17, 2017, the SEC issued two new Compliance & Disclosure Interpretations (C&DI) related to the use of non-GAAP financial measures by public companies. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and Item 10(e) of Regulation S-K. Regulation G and Item 10(e) require reconciliation to comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

My prior two-part blog series on non-GAAP financial measures, Regulation G and Item 10(e) of Regulation S-K can be read HERE and HERE.

GAAP continues to be criticized by the marketplace in general, with many institutional investors publicly denouncing the usefulness of the accounting standard. Approximately 90% of companies provide non-GAAP financial metrics to illustrate their financial performance and prospects. As an example, EBITDA is a non-GAAP number. I expect continued friction between the SEC’s enforcement of GAAP requirements and a company’s need to present non-GAAP numbers to satisfy the investment community.

New C&DI

The first of the new C&DI addresses whether forecasts provided to a financial advisor in relation to a business combination transaction would be considered non-GAAP financial measures requiring compliance with applicable rules. In particular, the SEC confirms that providing forecasts to a financial advisor in connection with a business combination transaction would not be considered non-GAAP financial measures.

Item 10(e)(5) of Regulation S-K and Rule 101(a)(3) of Regulation G provide that a non-GAAP financial measure does not include financial measures required to be disclosed by GAAP, SEC rules, or pursuant to specific government regulations or SRO rules that are applicable to a company. Accordingly, financial measures provided to a financial advisor would be excluded from the definition of non-GAAP financial measures, and therefore not subject to Item 10(e) of Regulation S-K and Regulation G, if and to the extent: (i) the financial measures are included in forecasts provided to the financial advisor for the purpose of rendering an opinion that is materially related to the business combination transaction; and (ii) the forecasts are being disclosed in order to comply with Item 1015 of Regulation M-A or requirements under state or foreign law, including case law, regarding disclosure of the financial advisor’s analyses or substantive work.

Although the disclosure of projections to a financial advisor in a business combination transaction does not implicate rules related to non-GAAP financial measures, that same disclosure in a registration statement, proxy statement or tender offer statement would need to comply with Regulation G and Item 10(e) of Regulation S-K.

In the second new C&DI, the SEC addresses the limited exemptions from the non-GAAP rules for communications relating to business combination transactions. In particular, Rule 425 of the Securities Act requires that certain business combination communications, that would not be considered solicitation materials in other contexts, be filed with the SEC, generally as part of a registration statement on Form S-4, proxy statement or tender offer statement. Likewise, limited solicitations under Exchange Act Rule 14a-12 and 14d-2(b)(2) that are made prior to filing a proxy statement are exempted from the non-GAAP measure requirements.

Other than the limited exemptions set forth in the rules listed above, and communications to a financial advisor, business combination communications must comply with Regulation G and Item 10(e) of Regulation S-K related to non-GAAP financial measures, including a reconciliation to comparable GAAP numbers and the reasons for presenting the non-GAAP numbers.

Refresher on Regulation G and Item 10(e) of Regulation S-K

Regulation G was adopted January 22, 2003 pursuant to Section 401(b) of the Sarbanes-Oxley Act of 2002 and applies to all companies that have a class of securities registered under the Securities Exchange Act of 1934 (“Exchange Act”) or that are required to file reports under the Exchange Act. The SEC permits companies to present non-GAAP financial measures in their public disclosures subject to compliance with Regulation G and Item 10(e) of Regulation S-K.

Regulation G governs the use of non-GAAP financial measures in any public disclosures including registration statements filed under the Securities Act of 1933 (“Securities Act”), registration statement or reports filed under the Exchange Act or other communications by companies including press releases, investor presentations and conference calls. Regulation G applies to print, oral, telephonic, electronic, webcast and any and all forms of communication with the public.

Item 10(e) of Regulation S-K governs all filings made with the SEC under the Securities Act or the Exchange Act and specifically prohibits the use of non-GAAP financial measures in financial statements or accompanying notes prepared and filed pursuant to Regulation S-X. Item 10(e) also applies to summary financial information in Securities Act and Exchange Act filings such as in MD&A.

Definition of non-GAAP financial measure and exclusions

A non-GAAP financial measure is any numerical measure of a company’s current, historical or projected future financial performance, position, earnings, or cash flows that includes, excludes, or uses any calculation not in accordance with U.S. GAAP.

Specifically, not included in non-GAAP financial measures for purposes of Regulation G and Item 10(e) are: (i) operating and statistical measures such as the number of employees, number of subscribers, number of app downloads, etc.; (ii) ratios and statistics calculated based on GAAP numbers are not considered “non-GAAP”; and (iii) financial measures required to be disclosed by GAAP (such as segment profit and loss) or by SEC or other governmental or self-regulatory organization rules and regulations (such as measures of net capital or reserves for a broker-dealer).

Non-GAAP financial measures do not include those that would not provide a measure different from a comparable GAAP measure. For example, the following would not be considered a non-GAAP financial measure: (i) disclosure of amounts of expected indebtedness over time; (ii) disclosure of repayments on debt that are planned or reserved for but not yet made; and (iii) disclosure of estimated revenues and expenses such as pro forma financial statements as long as they are prepared and computed under GAAP.

Neither Regulation G nor Item 10(e) applies to non-GAAP financial measures included in a communication related to a proposed business combination, the entity resulting from the business combination or an entity that is a party to the business combination as long as the communication is subject to and complies with SEC rules on communications related to business combination transactions. This exclusion only applies to communications made in accordance with specific business combination communications, such as those in Section 14 of the Exchange Act and the rules promulgated thereunder. As clarified in SEC C&DI on the subject, if the same non-GAAP financial measure that was included in a communication filed under one of those rules is also disclosed in a Securities Act registration statement or a proxy statement or tender offer statement, no exemption from Regulation G and Item 10(e) of Regulation S-K would be available for that non-GAAP financial measure.

Regulation G and Item 10(e) requirements

Together, Regulation G and Item 10(e) require disclosure of and a reconciliation to the most comparable GAAP numbers, the reasons for presenting the non-GAAP numbers, and govern the presentation format itself including requiring equal or greater prominence to the GAAP financial information.

As with any and all communications, non-GAAP financial measures are subject to the state and federal anti-fraud prohibitions. In addition to the standard federal anti-fraud provisions, Regulation G imposes its own targeted anti-fraud provision. Rule 100(b) of Regulation G provides that a company, or person acting on its behalf, “shall not make public a non-GAAP financial measure that, taken together with the information accompanying that measure and any other accompanying discussion of that measure, contains an untrue statement of a material fact or omits to state a material fact necessary in order to make the presentation of the non-GAAP financial measure, in light of the circumstances under which it is presented, not misleading.” As clarified in C&DI published by the SEC on May 17, 2016, even specifically allowable non-GAAP financial measures may violate Regulation G if they are misleading.

As is generally the case with SEC reporting, companies are advised to be consistent over time. Special rules apply to foreign private issuers, which rules are not discussed in this blog.

Below is a chart explaining the Regulation G and Item 10(e) requirements, which I based on a chart posted in the Harvard Law School Forum on Corporate Governance and Financial Regulation on May 23, 2013 and authored by David Goldschmidt of Skadden, Arps, Meagher & Flom, LLP. I made several additions to the original chart created by Skadden.

« Multiple Changes To Private Offering Compliance And Disclosure Interpretations (C&DI) The SEC And CFTC Joint Statements On Cryptocurrencies; Global Regulators Join In »

Multiple Changes To Private Offering Compliance And Disclosure Interpretations (C&DI)

Posted by Securities Attorney Laura Anthony | January 23, 2018 Tags: Exemption for Limited Offerings and Sales of Securities Not Exceeding $5 Million, Exemption for Limited Offers and Sales Without Regard to Dollar Amount of Offering, Filing of Notice of Sales (Form D), Multiple Changes To Private Offering Compliance And Disclosure Interpretations (C&DI), Regulation D, Rule 147, Rule 503, Rule 504, Rule 505, Rule 506

The SEC has been fine-tuning its Compliance and Disclosure Interpretations (C&DI), making multiple amendments, additions and deletions on September 20, 2017. The SEC made revisions to reflect changes to Rules 147 and 504, the repeal of Rule 505, as well as numerous non-substantive revisions throughout the C&DI to update for current rules and statutory references. Likewise, several C&DI have been removed that did not accurately reflect current rules.

On October 26, 2016, the SEC passed new rules to modernize intrastate and regional securities offerings. The final new rules amended Rule 147 to reform the rules and allow companies to continue to offer securities under Section 3(a)(11) of the Securities Act of 1933 (“Securities Act”). The SEC created a new Rule 147A to accommodate adopted state intrastate crowdfunding provisions. New Rule 147A allows intrastate offerings to access out-of-state residents and companies that are incorporated out of state, but that conduct business in the state in which the offering is being conducted. In addition, the SEC amended Rule 504 of Regulation D to increase the aggregate offering amount from $1 million to $5 million and to add bad-actor disqualifications from reliance on the rule. Finally, the SEC repealed the rarely used and now redundant Rule 505 of Regulation D.

Amended Rule 147 and new Rule 147A took effect on April 20, 2017. Amended Rule 504 took effect on January 20, 2017, and the repeal of Rule 505 was effective May 22, 2017. For a review of the rule changes, see my blog HERE.

This blog summarizes the substantive changes in the C&DI. Non-substantive changes were made to twenty-two C&DI, which the SEC marked with an asterisk (*) to indicate that they had been modified.

Regulation D

The SEC has made multiple changes to the C&DI related to Regulation D.

Rule 503 – Filing of Notice of Sales (Form D)

Rule 503 sets forth the requirements related to the filing of a Form D, notice of sales, with the SEC when completing an offering in reliance on Regulation D, including Rules 504 and 506. In 2009, the SEC issued a C&DI (Question 257.07) confirming that the filing of a Form D is not a condition to the availability of the exemptions under Rules 504 and 506.

All offers and sales of securities must comply with both federal and state securities laws, unless federal law specifically pre-empts state law compliance. The National Securities Markets Improvement Act of 1996 (“NSMIA”) amended Section 18 of the Securities Act to pre-empt state blue sky review of specified securities and offerings. The pre-empted securities are called “covered securities.” For more information on the NSMIA, see HERE and HERE.

The new C&DI (Question 257.08) bolsters the comfort level for issuers that fail to file a Form D (hopefully inadvertently) by confirming that the failure to file a Form D does not effect the Section 18 “covered security” status of securities issued under a Rule 506 offering.

Rule 504 – Exemption for Limited Offerings and Sales of Securities Not Exceeding $5 Million

The SEC has issued three new and withdrawn one C&DI related to Rule 504. Rule 504 provides an exemption from registration for offers and sales up to $5 million in securities in any twelve-month period. The purpose of Rule 504 is to assist small businesses in raising seed capital by allowing offers and sales of securities to an unlimited number of persons regardless of their level of sophistication – provided, however, that the offerings remain subject to the federal anti-fraud provisions; furthermore, general solicitation and advertising is prohibited unless sales are limited to accredited investors.

Rule 504, like Regulation A, is unavailable to companies that are subject to the reporting requirements of the Securities Exchange Act, are investment companies or are blank-check companies. Rule 144 has bad actor disqualification provisions matching those provisions in Rule 506. For more information on bad actor disqualification provisions, see HERE.

Rule 504 offerings do not pre-empt state law and are, in essence, a deferral to the states for small offerings. Rule 504 prohibits the use of general solicitation and advertising unless the offering is made (i) exclusively in one or more states that provide for the registration of the securities and public filing and delivery of a disclosure document; or (ii) in one or more states that piggyback on the registration of the securities in another state and they are so registered in another state; or (iii) exclusively according to a state law exemption that permits general solicitation and advertising so long as sales are made only to accredited investors (i.e., a state version of the federal 506(c) exemption).

The SEC has consistently viewed exempt offerings that involve general solicitation as public offerings. Accordingly, where a Rule 504 offering involves general solicitation or advertising, it would be considered a public offering.

One new C&DI (Question 258.03) confirms that a private fund which relies on either the Section 3(c)(1) or 3(c)(7) exemption from registration under the Investment Company Act of 1940 would not be able to make a public Rule 504 offering. The Investment Company Act exemptions in Sections 3(c)(1) and 3(c)(7) are not available to funds that conduct public offerings. If a private fund made a “public offering” of its securities, that private fund would no longer be able to rely on the applicable exclusion under Section 3(c)(1) or (7) and thus would be required to be registered under the Investment Company Act, unless another exclusion or exemption is available.

In the same C&DI, the SEC notes that a private fund could, however, rely on Rule 506(c) without losing its Investment Company Act exemption because Section 201(b)(2) specifically provides that offerings under Rule 506(c) are not considered “public offerings” under the federal securities laws. Interestingly, on November 17, 2016, the SEC issued a C&DI related to the integration of a 506(b) offering with a new 506(c) offering. Relying on Securities Act Rule 152, the SEC concluded that the two offerings would not integrate because the subsequent Rule 506(c) offering would be considered a “public offering.” See my blog HERE.

In new Question 258.05, the SEC confirms that the example for calculating aggregate offering price found in the instructions to Rule 504 does not contemplate integration of multiple offerings. Withdrawn Question 258.04 had also dealt with the calculation of the aggregate offering price.

In new Question 258.06, the SEC addresses the compliance date for the new Rule 504 bad actor disqualifications. That is, Rule 504 is not available to any issuer that is subject to disqualification under Rule 506(d) on or after January 20, 2017. On or after this date, issuers must determine if they are subject to bad actor disqualification any time they are offering or selling securities in reliance on Rule 504.

Rule 505

C&DI Questions 259.01 through 259.05 and 659.01 relating to Rule 505 have all been withdrawn consistent with the withdrawal of the Rule 505 exemption effective May 22, 2017.

Rule 506 – Exemption for Limited Offers and Sales Without Regard to Dollar Amount of Offering

Rule 506(b) allows offers and sales to an unlimited number of accredited investors and up to 35 unaccredited investors, provided however that if any unaccredited investors are included in the offering, certain delineated disclosures, including an audited balance sheet and financial statements, are provided to potential investors. Rule 506(b) prohibits the use of any general solicitation or advertising in association with the offering. Rule 506(c) requires that all sales be strictly made to accredited investors and adds a burden of verifying such accredited status to the issuing company.

The SEC did not add any new C&DI on Rule 506 but did withdraw Question 260.02, which had addressed the now outdated preclusion of general solicitation or advertising for any Rule 506 offering.

Rule 147

For a complete summary of Rule 147, see HERE. The SEC has each added one and deleted one C&DI related to determining residence of a trust.

Section 3(a)(11) of the Securities Act of 1933, as amended (Securities Act) provides an exemption from the registration requirements of Section 5 for “[A]ny security which is a part of an issue offered and sold only to persons resident within a single State or Territory, where the issuer of such security is a person resident and doing business within or, if a corporation, incorporated by and doing business within, such State or Territory.” Section 3(a)(11) is often referred to as the Intrastate Exemption. Rule 147, as amended is a safe harbor under Section 3(a)(11) of the Securities Act.

Rule 147 defines the residence of a purchaser that is a legal entity, such as a corporation or trust, as the location where, at the time of the sale, it has its principal place of business. The Rule specifies that if a trust is not a separate legal entity, it is deemed to be a resident of each state or territory in which its trustee is, or trustees are, resident.

The added C&DI (541.03) provides that where a family trust is not a separate legal entity and has two trustees residing in two separate states, an issuer may offer and sell securities to the trust, in reliance on Rule 147, as long as the Rule 147 offering is being conducted in one of the states in which a trustee resides.

The deleted C&DI (541.02) had provided that a trust could not be offered securities where the trust had a non-resident beneficiary that held a 50% interest in the trust.

The Author

Laura Anthony, Esq.
Founding Partner
Legal & Compliance, LLC
Corporate, Securities and Going Public Attorneys
330 Clematis Street, Suite 217
West Palm Beach, FL 33401
Phone: 800-341-2684 – 561-514-0936
Fax: 561-514-0832
LAnthony@LegalAndCompliance.com
www.LegalAndCompliance.com
www.LawCast.com

Securities attorney Laura Anthony and her experienced legal team provides ongoing corporate counsel to small and mid-size private companies, OTC and exchange traded issuers as well as private companies going public on the NASDAQ, NYSE MKT or over-the-counter market, such as the OTCQB and OTCQX. For nearly two decades Legal & Compliance, LLC has served clients providing fast, personalized, cutting-edge legal service. The firm’s reputation and relationships provide invaluable resources to clients including introductions to investment bankers, broker dealers, institutional investors and other strategic alliances. The firm’s focus includes, but is not limited to, compliance with the Securities Act of 1933 offer sale and registration requirements, including private placement transactions under Regulation D and Regulation S and PIPE Transactions as well as registration statements on Forms S-1, S-8 and S-4; compliance with the reporting requirements of the Securities Exchange Act of 1934, including registration on Form 10, reporting on Forms 10-Q, 10-K and 8-K, and 14C Information and 14A Proxy Statements; Regulation A/A+ offerings; all forms of going public transactions; mergers and acquisitions including both reverse mergers and forward mergers, ; applications to and compliance with the corporate governance requirements of securities exchanges including NASDAQ and NYSE MKT; crowdfunding; corporate; and general contract and business transactions. Moreover, Ms. Anthony and her firm represents both target and acquiring companies in reverse mergers and forward mergers, including the preparation of transaction documents such as merger agreements, share exchange agreements, stock purchase agreements, asset purchase agreements and reorganization agreements. Ms. Anthony’s legal team prepares the necessary documentation and assists in completing the requirements of federal and state securities laws and SROs such as FINRA and DTC for 15c2-11 applications, corporate name changes, reverse and forward splits and changes of domicile. Ms. Anthony is also the author of SecuritiesLawBlog.com, the OTC Market’s top source for industry news, and the producer and host of LawCast.com, the securities law network. In addition to many other major metropolitan areas, the firm currently represents clients in New York, Las Vegas, Los Angeles, Miami, Boca Raton, West Palm Beach, Atlanta, Phoenix, Scottsdale, Charlotte, Cincinnati, Cleveland, Washington, D.C., Denver, Tampa, Detroit and Dallas.

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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« SEC and NASAA Statements on ICOs and More Enforcement Proceedings SEC Issues C&DI On Use Of Non-GAAP Measures »

SEC and NASAA Statements on ICOs and More Enforcement Proceedings

Posted by Securities Attorney Laura Anthony | January 16, 2018 Tags: cryptocurrencies, DAO, ICO, ICOs, Initial Coin Offerings, NASAA, SEC, SEC and NASAA Statements on ICOs, SEC and NASAA Statements on ICOs and More Enforcement Proceedings

The message from the SEC is very clear: participants in initial coin offerings (ICO’s) and cryptocurrencies in general need to comply with the federal securities laws or they will be the subject of enforcement proceedings. This message spreads beyond companies and entities issuing cryptocurrencies, also including securities lawyers, accountants, consultants and secondary trading platforms. Moreover, the SEC is not the only watchdog. State securities regulators and the plaintiffs’ bar are both taking aim at the crypto marketplace. Several class actions have been filed recently against companies that have completed ICO’s.

After a period of silence, on July 25, 2017, the SEC issued a Section 21(a) Report on an investigation and related activities by the DAO, with concurrent statements by both the Divisions of Corporation Finance and Enforcement. On the same day, the SEC issued an Investor Bulletin related to ICO’s. For more on the Section 21(a) Report, statements and investor bulletin, see HERE. Since that time, the SEC has engaged in a steady flow of enforcement proceedings and statements on the subject.

The DAO report centered on a traditional analysis to determine whether a token is a security and thus whether an ICO is a securities offering. In particular, the nature of a digital asset (“coin” or “token”) must be examined to determine if it meets the definition of a security using established principles, including the Howey Test. See HERE for a discussion on the Howey Test. The report also pointed out that participants in ICO’s are subject to federal securities laws to the same extent they are in other securities offerings, including broker-dealer registration requirements, and that securities exchanges providing for trading must register unless an exemption applies.

On November 1, 2017, the SEC issued a warning to the public about the improper marketing of certain ICO’s, token offerings and investments, including promotions and endorsements by celebrities. Celebrities, like any other promoter, are subject to the provisions of Section 17(b) of the Securities Act, including the requirement to disclose the nature, scope, and amount of compensation received in exchange for the promotion. For more on Section 17(b) and securities promotion in general, see HERE.

On December 11, 2017, SEC Chairman Jay Clayton issued a statement on cryptocurrencies and initial coin offerings. In that statement, Clayton drilled down on the sudden rise of “non-security” ICO’s, now being referred to as “utility tokens,” clearly conveying the message that if a token has attributes of a security, it will be governed as a security. To make the message even clearer, also on December 11, 2017, the SEC halted the ICO by Munchee, Inc., disagreeing with Munchee’s statements and conclusions that its token was a “utility token” and not a security.

This was not the first ICO halt. On December 4, 2017, the SEC halted the ICO by PlexCorps, including outright fraud with the claims of an unregistered offering. The SEC has also taken aim at companies that are in the crypto space in general, having halting the trading of The Crypto Company on December 19, 2017 after a 2,700% stock price increase. This was not the first trading halt, either. Others include American Security Resources Corp, halted on August 24, 2017; First Bitcoin Capital, halted on August 23, 2017; CIAO Group, halted on August 9, 2017; and Sunshine Capital on June 7, 2017.

More recently, on January 5, 2018, the SEC halted the trading of UBI Blockchain Internet, Ltd. citing questions regarding the accuracy of information in SEC filings and concerns about market activity, which was the epitome of an unexplained stock surge.

On August 28, 2017, the SEC issued an investor alert warning about public companies making ICO-related claims. The alert specifically mentioned the trading suspensions and warned that ICO claims could be a sign of a pump-and-dump scheme.

On January 4, 2018, Chair Clayton issued another statement, this time joined by Commissioners Kara Stein and Michael Piwowar, commenting on the North American Securities Administrators Association (NASAA) statement made the same day. The NASAA is a group comprised of state securities regulators, which, among other functions, acts as a communication arm for the individual state regulators on important marketplace topics.

Jay Clayton’s December 11, 2017 Statement

Jay Clayton begins his December 11, 2017 statement with an acknowledgement of the “tales of fortunes made and dreamed to be made,” which is a perfect description of ICO mania. Keeping with the SEC theme under Clayton, he then addresses ICO considerations for Main Street investors. In addition to warning of fraud and misrepresentations, ICO’s and cryptocurrency trading is a national marketplace; invested funds may quickly move overseas. Furthermore, the SEC may not be able to gain jurisdiction or pursue bad actors or lost funds in other countries.

The fact is that as of today, no cryptocurrency offerings have been registered with the SEC. Although Jay Clayton doesn’t talk about what registration will really mean for an ICO, I note that, since registration is the process of ferreting out disclosures, it will force an entity issuing an ICO to be clear about the usefulness of its token, if any, and the risk factors not only associated with its token, but the marketplace as a whole. My firm is currently working on registration statements as well as private offering documents for ICO’s and blockchain technology entities and the complexity of this new industry and technology, and uncertainty associated with legalities (including not only securities matters, but the implication of swap and commodity transactions, tax ramifications, intellectual property matters, etc.) is confounding to even the best and brightest.

The importance of the involvement and efforts by market professionals is not lost on the SEC. In the beginning, many ICO’s, believing that this new investment vehicle was somehow not a security and therefore outside the parameters of the securities laws and SEC jurisdiction, forewent the advice of legal counsel and other professionals. Now that this belief has been rectified, in his statement, Jay Clayton reminds market professionals of their gatekeeping duties. Chair Clayton states, “[I] urge market professionals, including securities lawyers, accountants and consultants, to read closely the investigative report we released earlier this year (the “21(a) Report”) and review our subsequent enforcement actions.”

He continues: “[F]ollowing the issuance of the 21(a) Report, certain market professionals have attempted to highlight utility characteristics of their proposed initial coin offerings in an effort to claim that their proposed tokens or coins are not securities. Many of these assertions appear to elevate form over substance. Merely calling a token a ‘utility’ token or structuring it to provide some utility does not prevent the token from being a security….. On this and other points where the application of expertise and judgment is expected, I believe that gatekeepers and others, including securities lawyers, accountants and consultants, need to focus on their responsibilities. I urge you to be guided by the principal motivation for our registration, offering process and disclosure requirements: investor protection and, in particular, the protection of our Main Street investors.” The bold emphasis was from the SEC, not added by me. The message could not be clearer.

Attorneys and other professionals are not the only groups that the SEC is taxing with gatekeeper responsibilities. Jay Clayton adds: “[I] also caution market participants against promoting or touting the offer and sale of coins without first determining whether the securities laws apply to those actions. Selling securities generally requires a license, and experience shows that excessive touting in thinly traded and volatile markets can be an indicator of ‘scalping,’ ‘pump and dump’ and other manipulations and frauds. Similarly, I also caution those who operate systems and platforms that effect or facilitate transactions in these products that they may be operating unregistered exchanges or broker-dealers that are in violation of the Securities Exchange Act of 1934.” Again, the bold emphasis is not mine. Although Jay Clayton does not indicate so, I am unaware of any properly licensed secondary market or exchange for the trading of cryptocurrencies at this time. TZero is properly licensed, but not up and functioning as of the date of this blog.

Jay Clayton’s statement is not all negative. He recognizes that ICO’s can be an effective method to raise capital and fund projects. He also recognizes that not all cryptocurrencies are securities. A specific example would be an in-app game with token purchases that can only be used to reach another level. However, Clayton points out that “[B]y and large, the structures of initial coin offerings that I have seen promoted involve the offer and sale of securities and directly implicate the securities registration requirements and other investor protection provisions of our federal securities laws.”

The Division of Enforcement has been instructed to vigorously police the ICO marketplace. Finally, the SEC encourages investors to conduct thorough due diligence before making an ICO investment. In that regard, he provides a list of basic questions that should be asked and considered before making any investment.

January 4, 2018 Statements by Chair Clayton and Commissioners Kara Stein and Michael Piwowar

On January 4, 2018, Chair Clayton, Commissioners Kara Stein and Michael Piwowar issued a statement commending the North American Securities Administrators Association’s (NASAA) own statement made the same day addressing concerns with ICO’s and cryptocurrencies. The NASAA is a group comprised of state securities regulators.

The SEC’s top brass specifically point out that cryptocurrencies are not, in fact, currencies in that they are not backed or regulated by sovereign governments and seem to be focused on a method of capital raising as opposed to mediums of exchange. Reiterating its other messaging, the SEC reminds the public that offerings and their participants must comply with the state and federal securities.

NASAA Statement on Cryptocurrencies and ICO’s

NASAA begins its statement with a consistent theme to the SEC, warning Main Street investors to be cautious about investments involving cryptocurrencies. NASAA, also like the SEC, encourages potential investors to conduct due diligence and ask questions before making an ICO (or any) investment.

NASAA includes a laundry list of risks and issues with ICO’s and crypto-related investments. NASAA points out that unlike FIAT or traditional currencies, cryptocurrencies have no physical form and typically are not backed by tangible assets (though I note that this is a void that is quickly being addressed by new tokens backed by physical assets and commodities).

Furthermore, cryptocurrencies are not insured, not controlled by a central bank or other governmental authority, are subject to very little if any regulation, and cannot be easily exchanged for other commodities. Cryptocurrencies are susceptible to breaches, hacking and other cybersecurity risks, including on both the ICO issuer side and the investor side through direct breaches into a wallet or other digital storage. ICO’s are a global investment vehicle and, as such, US regulators may have no ability to recover lost funds or pursue bad actors. Likewise, private civil proceedings could prove futile.

Moreover, the high volatility and high risk of cryptocurrency investments make them unsuitable for most investors. In both its statement and a very simple investor-directed animated video on the subject, NASAA clearly states that investors could lose all of their money in a crypto-related investment.

Regulators almost unanimously believe that cryptocurrencies involve a high risk of fraud. NASAA includes a list of obvious red flags, including guaranteed high returns, unsolicited offers, sounds too good to be true, pressure to buy immediately, and unlicensed sellers.

NASAA now lists ICO’s and cryptocurrency-related investment products as an emerging investor threat for 2018.

Further Reading on DLT/Blockchain and ICO’s

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a discussion on the Section 21(a) Report on the DAO investigation, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICO’s, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICO’s and accounting implications, see HERE.

For an update on state distributed ledger technology and blockchain regulations, see HERE.

The Author

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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« The SEC’s 2017 Enforcement Priorities And Results Multiple Changes To Private Offering Compliance And Disclosure Interpretations (C&DI) »

The SEC’s 2017 Enforcement Priorities And Results

Posted by Securities Attorney Laura Anthony | January 9, 2018 Tags: 2017, SEC, The SEC's 2017 Enforcement Priorities And Results

No more broken windows! In a series of speeches by various top brass at the SEC followed by the publication of the SEC Enforcement Division 2017 Report on results and priorities, the SEC has confirmed both directly and through its actions that the era of “broken windows” enforcement is over. The broken windows policy was first shepherded by Mary Jo White in 2013 and was one in which the SEC committed to pursue infractions big and small and to investigate, review and monitor all activities. The idea was that small infractions lead to bigger infractions, and the securities markets have had the reputation that minor violations are overlooked, creating a culture where laws were treated as meaningless guidelines.

Michael Piwowar has been a critic of broken windows since its inception. In a speech to the Securities Enforcement Forum in 2014, Mr. Piwowar stated, “[I]f every rule is a priority, then no rule is a priority.” He continued, “[I]f you create an environment in which regulatory compliance is the most important objective for market participants, then we will have lost sight of the underlying purpose for having regulation in the first place. Rather than enabling vital and important economic activity, we will have unnecessarily shackled it – and our country will be far worse off from the absence of such activity.”

Given the power to make a change, Commissioner Michael Piwowar and Chair Jay Clayton have signaled an adjustment in enforcement priorities throughout the year. In February 2017, then acting Chair Michael Piwowar revoked the subpoena authority from SEC staff, leaving the Division of Enforcement with the sole authority to approve a formal order of investigation and issue subpoenas. Mr. Piwowar had been a vocal critic of both the staff subpoena power and the manner in which the power was created since its inception. He has also been a vocal critic of the SEC’s investigative power, believing it has too much power and too little oversight. For more on the SEC subpoena power, Mr. Piwowar’s views, and the early stage setting for the current enforcement priorities, see HERE.

In his October 4, 2017 testimony on the SEC’s Agenda, Operations and Budget before the Committee on Financial Services, Chair Jay Clayton reiterated his commitment to rooting out bad actors and fraud, including pump-and-dump schemes, insider trading, and serious reporting and disclosure violations. Certainly, a review of published enforcement proceedings has illustrated that commitment. Mr. Clayton also laid the groundwork for more focused enforcement, stating, “I have asked the Division of Enforcement to evaluate regularly whether we are focusing appropriately on retail investor fraud and investment professional misconduct, insider trading, market manipulation, accounting fraud and cyber matters. I believe our Main Street investors would want us to focus on these areas.”

In July 2017, Chair Clayton announced a top priority and philosophy of protecting “Main Street investors,” which buzzwords are now repeated often in SEC communications, including press releases and speeches.

On October 26, 2017, Steven Peikin, co-director of the SEC Division of Enforcement, confirmed the death knell for the broken windows policy. In a speech, Mr. Peiken told conference attendees that the SEC would “have to be selective and bring a few cases to send a broader message rather than seep the entire field.” Mr. Peiken also suggested stronger communication between the Division of Enforcement and investigative targets, and an environment that fosters cooperation. In that regard, the SEC should communicate the benefits of cooperation and specifically how a company can merit cooperation credit. In that regard, the SEC will again encourage self-reporting and remediation, a prior policy that lost its wind in the 2001 Enron crisis.

Clearly, the change is driven by more than philosophy. The SEC budget has effectively been frozen, and more money needs to be spent on cybersecurity matters than ever before. See HERE. The SEC Division of Enforcement could have at least 100 fewer investigators and supervisors over the next year, as those lost to attrition will not be replaced.

Mary Jo White’s policy of forcing admissions of guilt in enforcement settlements may also have reached its pinnacle. In June 2013, the SEC announced that it would require that a settling party admit wrongdoing as part of a settlement to act as a further deterrent and bolster public accountability. In addition to reputational damage, this policy had legal evidentiary significance that could be used in civil matters, including shareholder lawsuits. For more on this, see HERE.

In his October 2017 speech, Mr. Piekin talked about the admissions policy, stating, “I think when people resolve cases with the commission [and] neither admit nor deny but agree to all the points of relief, I don’t think most people in the world say, ‘Boy, they really got away with that.’” That doesn’t mean the policy will disappear, but it may revert to its prior reiteration, where only those with related criminal cases will be asked for a guilt admission.

Division of Enforcement Annual Report on Results and Priorities

On November 15, 2017, the Division of Enforcement issued its annual report (Annual Report) on results and priorities, reiterating the mission and focus on the protection of Main Street investors. The Annual Report cites five core principles, including: (i) focus on Main Street (retail) investors, including accounting fraud, sales of unsuitable products, pursuit of unsuitable trading strategies, pump-and-dump schemes and Ponzi schemes; (ii) focus on individual accountability to maximize deterrence and prevent recidivists from continuing improper activities; (iii) keeping pace with technological changes, including all cybersecurity matters; (iv) imposing sanctions that support enforcement goals; and (v) constantly assessing the allocation of resources.

The Annual Report reiterates initiatives announced earlier this year, including the new Cyber Unit and Retail Strategy Task Force (see HERE), while confirming its commitment to long-standing enforcement goals. The top current goals include risks posed by cyber-related misconduct; issues raised by the activities of investment advisers, broker-dealers, and other registrants; financial reporting and disclosure issues involving public companies; and insider trading and market abuse.

During fiscal year ended (FYE) September 2017, the SEC brought 754 enforcement proceedings, returned $1.07 billion to harmed investors and obtained judgment and orders for more than $3.789 billion in disgorgement and penalties. During FYE ended September 2016, the SEC brought 868 actions and obtained judgements and orders for more than $4 billion in disgorgement and penalties. For more on the 2016 report, see HERE.

Broken down by type of case, the most cases were brought related to issuer reporting violations including audit and accounting problems, followed by securities offerings, then investment advisor or investment company violations, then broker-dealer violations, followed by insider trading, then market manipulation. A number of cases were also brought for public finance abuse, FCPA violations and transfer agent issues.

Interestingly, the SEC suspended trading in 309 companies in FYE 2017, a 55% increase from 2016. Trading suspensions are generally related to market manipulation and microcap fraud, and are a very successful tool to stop these problems in their tracks. Asset freezes were pretty even in both years, with 35 court-ordered asset freezes in 2017 and 33 in 2017. Likewise, the imposition of bars and suspensions has remained a constant, with 625 in 2017 and 650 in 2016.

The Author

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State Distributed Ledger Technology and Blockchain Regulations

Posted by Securities Attorney Laura Anthony | January 2, 2018 Tags: Blockchain Regulations, Distributed Ledger Technology Regulations, State Blockchain Regulations, State Distributed Ledger Technology and Blockchain Regulations, State Distributed Ledger Technology Regulations, Uniform Regulation of Virtual Currency Business Act, Uniform VCBA

In a time of rapidly changing regulations and policies on all securities industry and corporate finance topics, and the development of distributed ledger technology (DLT or blockchain) and associated initial cryptocurrency offerings (ICO’s), I have never had so many topics in the queue to write about. With a once-a-week blog, I will just keep working through the list, reporting on all developments, some quicker than others. In this blog, I am circling back to DLT with a synopsis of state law developments and the Uniform Law Commission’s (ULC) approved Uniform Regulation of Virtual Currency Business Act (Uniform VCBA).

Uniform Regulation of Virtual Currency Business Act (Uniform VCBA)

On July 19, 2017, the Uniform Law Commission (ULC) approved Uniform Regulation of Virtual Currency Business Act (Uniform VCBA) to be used as a model for states seeking to adopt such legislation. The VCBA is a money-transmitting or payment-processing-based legislation. The VCBA defines a money transmitter in an effort to provide clarity on what businesses are required to be licensed. The VCBA also provides an anti-money laundering (AML) framework that mirrors FinCEN requirements.

The VCBA focuses on control over the currency and transaction and requires licensing by any business that has the “power to execute unilaterally or prevent indefinitely a virtual currency transaction.” This definition is meant to distinguish virtual wallets that merely hold an individual’s virtual currency and process a transaction at the behest of such owner, without any additional powers.

Delaware

The Delaware Blockchain Initiative is the state’s program to welcome and encourage blockchain businesses and to establish regulatory clarity for their operations and the use of blockchain technology overall, including DLT.

The August 1, 2017 amendments to the Delaware General Corporation Law (DGCL) Section 219, 224 and 232 will allow Delaware private companies to use DLT to maintain shareholder records, including authorized, issued, transferred, and redeemed shares, on a DLT system. As of now, the amendments to the DGCL are limited to private companies; however, the state of Delaware is in talks with the SEC related to implementing the technology for public companies.

DGCL Sections 219 and 224 have been amended to permit corporations to rely on a DLT as a stock ledger itself, potentially eliminating a separate transfer agent for private companies. Section 219(c) defines a “stock ledger” to include “one or more records administered by or on behalf of the corporation.” Section 224 provides that any records “administered by or on behalf of the corporation” could include “one or more distributed electronic networks for databases.”

A ledger must also: (i) be convertible into clearly legible paper form within a reasonable time; (ii) be able to be used to prepare the list of stockholders specified in Sections 219 and 220 (related to stockholder demands to inspect corporate books and records); (iii) must be able to record information and maintain records for various statute sections related to shareholdings, including those related to consideration for partly paid shares, the transfer of shares for collateral, pledged shares and voting trusts; and (iv) be able to records transfers of shares in compliance with the Delaware Uniform Commercial Code.

Delaware is currently working in collaboration with a private company, Symbiont, to put together “smart securities,” which are allegedly impossible to counterfeit. The ledger could be maintained by either a closed or open group of participants. The ledger and any transfers would be updated instantaneously, effectively allowing for T+0 settlement of trades.

Nevada

Preceding Delaware by a month, on June 5, 2017, Nevada’s governor signed Senate Bill 398 into law, confirming that blockchain records have legally binding status. Unlike Delaware, Nevada’s regulations do not amend its corporate statutes (i.e., Chapter 78, Nevada’s Private Corporation Law), but rather, similar to Arizona, amends Chapter 719, Nevada’s Uniform Electronic Transactions Act.

Nevada’s statute defines blockchain as an electronic record of transactions or other data which is: (i) uniformly ordered; (ii) redundantly maintained or processed by one or more computers or machines to guarantee the consistency or nonrepudiation of the recorded transactions or other data; and (iii) validated by the use of cryptography.

The Nevada statute prohibits local governments from imposing taxes or fees on the use of a blockchain; requiring a certificate, license or permit to use a blockchain; or imposing any other requirement related to the use of blockchain. Moreover, the Nevada statute provides “written” status to blockchain records. In particular, “if a law requires a record to be in writing, submission of a blockchain which electronically contains the record satisfies the law.”

Arizona

Prior to both Nevada and Delaware, in March 2017 Arizona passed House Bill 2417 into law, confirming the legal status of blockchain records. Like Nevada, Arizona gives smart contracts and blockchain signatures legal binding status. In addition, the Arizona statute confirms that a smart contract has legally binding status, as would any other legal form of contract. Also like Nevada, Arizona’s provision is an amendment to its electronic transactions statute and not its corporate governance provisions.

Arizona defines “blockchain technology” as “distributed ledger technology that uses a distributed decentralized, shared and replicated ledger, which may be public or private, permissioned or permissionless, or driven by tokenized crypto economics or tokenless. The data on the ledger is protected with cryptography, is immutable and auditable and provides an uncensored truth.”

Arizona defines a “smart contract” as “an event driven program, with state, that runs on a distributed decentralized, shared and replicated ledger and that can take custody over and instruct transfer of assets on that ledger.”

Vermont

Vermont defines “blockchain technology” as “a mathematically secured, chronological and decentralized consensus ledger or database, whether maintained via Internet interaction, peer-to-peer network, or otherwise.” The Vermont statute confirms that blockchain records will be considered regular business records and makes blockchain records admissible as evidence under the Vermont rules of evidence.

Miscellaneous Virtual Currency Provisions

Multiple states, including Connecticut, New York, Oregon and Tennessee, have enacted legislations defining virtual currency and requiring money transmitters or payment processors which exchange virtual currency for U.S. dollars, to be licensed. The New York statute (the BitLicense Regulation) has received a lot of pushback, with many claiming it is vague or overly difficult to comply with, causing many in the business to avoid New York jurisdiction.

Further Reading on DLT/Blockchain and ICO’s

For an introduction on distributed ledger technology, including a summary of FINRA’s Report on Distributed Ledger Technology and Implication of Blockchain for the Securities Industry, see HERE.

For a summary on a report on an investigation related to the DAO’s ICO, statements by the Divisions of Corporation Finance and Enforcement related to the investigative report and the SEC’s Investor Bulletin on ICO’s, see HERE.

For a summary of SEC Chief Accountant Wesley R. Bricker’s statements on ICO’s and accounting implications, see HERE.

The Author

Contact Legal & Compliance LLC. Technical inquiries are always encouraged.

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